Elcotel Readies for New Millennium

Posted: 04/1998

Elcotel Readies for New Millennium

By Bob Titsch JR.

With revenues plummeting and its stock hovering around 13 cents a share, Elcotel Inc.
(NASDAQ:ECTL) was in considerable financial distress in 1991. The business was burdened
with debt, struggling to keep the support of suppliers and lendors, and in default to its
major creditors.

Since then the payphone manufacturer has grown annual revenue 500 percent; been
recognized as No. 2 in growth for small companies by Business Week magazine;
achieved ISO 9002 certification; developed what customers call the industry’s most
advanced network management system; reduced circuit board failure rates dramatically;
broadened its product line; and extended its reach by acquiring the payphone assets of
Lucent Technologies and merging with Technology Service Group Inc. (TSG).

As a result, the company that owned a 7 percent market share in the early ’90s now
captures 40 percent of the domestic payphone equipment market, according to equity
research firm Hoak, Breedlove Wesneski and Co., which recently gave Elcotel a
"buy" rating at $5.50 a share and projects a 12-month price target of $9.

Elcotel also has developed a burgeoning international business unit, completing a
metamorphosis from struggling payphone circuit board and software manufacturer to
international public access terminal colossus. It’s a compelling story, and one that means
more to the payphone industry than people may realize without a deep examination of
Elcotel’s mission and plan to realize that mission.

Gray Matters

In the late ’80s and early ’90s, Elcotel pursued several undertakings unrelated to its
core product. As a result, the company lacked direction and focus, according to Hugh
Durden, vice president and general manager of U.S. sales. "The person who
re-established our focus on payphones and serving the needs of independent payphone
providers was Tracey Gray."

Tracey L. Gray, a 30-year veteran with AT&T, had read about Elcotel and called C.
Shelton James, the newly elected chairman of the board and chief executive officer charged
with forming a long-term recovery plan. "I kind of volunteered for duty," says
Gray. "I was already moving to Tampa and had no intention of joining Elcotel, but the
company intrigued me and I thought I could help."

James and the board hired Gray as president and chief operating officer just two weeks
after Durden, and they immediately hit the road to talk with customers. "Despite our
problems, we had some very loyal customers who depended on our product," says Gray,
now president and CEO of the company. "I said we needed their help, and offered them
an incentive to pay off their notes in advance. In three weeks, we raised a substantial
cash payment from very, very loyal customers."

People Power

Elcotel then brought in stronger management, including Vice President of Operations
Kenneth Noack, to streamline its lines of business and improve product quality. And
improve it did: Company documents show that circuit board failure rates have improved from
8 percent to less than three-tenths of 1 percent, an achievement Noack attributes to
people and process.

"We have a different philosophy on people and a pretty forward-
thinking theory with respect to operations and manufacturing," Noack says. "We
don’t have any inspectors on the floor. The employees themselves are the inspectors and
when an ISO auditor comes in, they don’t talk to me, they talk to the people laboring in
our production department. They know what quality means. They know what quality is. They
know what quality work is.

"The production processes have been improved dramatically and some of it has to do
with what I brought along, but most of it has to do with the people," he adds.
"There’s a theory out there that people check their brains at the door, sit at their
bench, do their job and go home, and that’s not true. If there’s anybody who knows how to
do things better, it’s the people doing the job."

These people are so effective that Elcotel reduced its product repair staff because it
suffered from the "Maytag Syndrome," or didn’t have enough work, according to
Michael Nastanski, senior director of marketing.

Brainware

Elcotel had approximately 75 employees in 1992. Today, 76 of its 350 employees are
engineers and technical personnel. Fifteen of them are off-site pursuing next-generation
technology in what Vice President of Engineering and Development Henry "Bill"
Swanson calls Skunkworks, a term coined by Lockheed Martin several years ago as a place
where engineering staff are left to do nothing but create.

"Payphones are rapidly becoming a commodity product," says Swanson, who spent
five years with Dell Computers running desktop design. "I watched PCs go from a
technology product to a commodity product overnight. They cost about the same. They had
the same features. There was very little difference.

"We recognized last year that the same thing was happening with payphones,"
he continues. "So we started thinking about the next step, which we define as an
enhanced payphone. It’s a basic payphone with the added functionality of a card reader
that accepts swipe cards and smart cards, and can support the European chip card through
the use of the Security Access Module (SAM), the first step toward true electronic
commerce. It also has a visual display–either LCD or vacuum fluorescent–that augments
audible instructions and allows for downloadable display advertising capability so
customers can sell advertising to companies like Yellow Cab. It also has a data port
feature, enticing Internet usage to increase revenues."

Elcotel is releasing two versions to satisfy the high-end, high profile market: The
Eclipse is housed in the GTE-style case, which most independent payphone owners utilize;
the Comet is housed in the Western Electric-style case, used primarily by telcos. They
both have a more integrated logic board with fewer parts, more memory so additional
feature sets can be added later, and double the modem speed to increase data downloads.

What Swanson seems particularly proud of, however, is Elcotel’s firmware/software,
which is updated about every three months. The Payphone Network Manager (PNM) Plus allows
payphone operators to download the characteristics of payphones to get call detail records
(CDRs) that are used to troubleshoot errors, track volume in coin boxes and generate
reports for users, among other things. It also has an export capability that many IPPs use
to export into business programs such as Quicken and Quick Book so they don’t have to
translate the data themselves.

"It’s regarded as the standard in the industry," says Swanson.

International Intrigue

International markets are attractive to Elcotel not only because they are high-growth
markets, but also because they subsidize next-generation technology. Four years ago,
Elcotel did not have an electronic coin mechanism, but was forced to adopt one out of
necessity to support a program in Bolivia. Shortly after, electronic coin mechanisms
became a standard part of the company’s domestic product offerings. Three years ago, a
deal in Mexico pushed the firm into developing a multilingual LCD display. Today these
displays are required in most international markets and they are beginning to crop up in
the United States.

"International business definitely presents our greatest growth opportunity, but
that’s not what excites us about the international market," says Gray. "It’s the
fact that the international payphone market’s technology evolution leads the domestic
market. For example, smart card and chip card applications are commonplace in Europe, but
they won’t be prevalent in this country for four to five years. Americans are used to
paying for service in arrears, not in advance. But people in this country will eventually
accept the electronic purse.

"International markets are attractive to us because they drive technology,"
says Gray. "Serving them fills out an opportunity window and gives us the ability to
infuse new technology that will eventually find its way into the domestic market."

Gray projects that international business eventually will account for 30 percent to 40
percent of Elcotel’s revenue.

The Big Picture

Elcotel’s acquisition of Lucent’s payphone assets and its merger with TSG prove that
the payphone industry is much more sophisticated than it used to be. With the help of the
American Public Communications Council (APCC) and state associations, the private payphone
sector has mobilized, proliferated and matured into a high-technology community ready for
bear.

Elcotel’s recent strategic positioning is on the same level as the recent maneuvers by
much larger, more visible computer and data communications companies. The goal: Through
acquisitions, generate cost reductions, technological advantages and improved capability
to address new markets.

When both deals closed late last year, Elcotel instantly expanded its smart-phone
technology with Lucent’s and TSG’s line of upgrade modules and replacement components;
streamlined inventories because those companies’ components share similar design elements;
and, through their business relationships, extended its reach into the public (telco)
payphone and international markets.

Historically, Elcotel has served the private payphone sector, but Lucent and TSG were
major suppliers to public telephone companies, which own approximately 1.6 million of the
2.2 million payphones deployed domestically.

The acquisitions have made Elcotel the market-share leader in the public sector at a
time when that segment is incented to upgrade and compete with the smart-phone technology
in the unregulated environment of private operators (the majority of telcos’ installed
base of non-intelligent payphones are candidates for upgrades to intelligent
microprocessor technology). These acquisitions added new capabilities in refurbishment, an
extensive parts line, and technical depth that will benefit all of the company’s
customers, according to Durden.

"There will be more skirmishes over dial-around compensation and jurisdictional
issues," says Gray. "But over time, those things will be settled and the
principles of the Telecommunications Act of 1996 will be realized. The telco payphone
operators will look more like the large regional private operators. They’ll be more
cost-effective. They’ll be much less beaurocratic. And they’ll be much more responsive to
market forces."

In four or five years, Gray envisions a payphone market with hundreds of small- and
medium-sized localized payphone operators, and 20 to 30 very large ones that have control
over 60 percent to 70 percent of all public access terminals. Those operators, he
believes, will require more advanced technology to deliver multimedia applications.

"We’ll see a mix of public terminals that can accommodate voice, video and
data," says Gray. "We’re trying to build a business that not only can stay
abreast of that technology and deliver it, but also structure our organization in such a
way that it can effectively supply customers through what surely will be a
revolution."

In other words, it’s not the total number of terminals that will grow, but the
terminals themselves that will change. And Elcotel will be ready.

Says Nastanski: "We want all of our customers to be able to rely on Elcotel for
any of their product or service needs."